I tend to like nice guys. Don’t we all? One of my favourite investors is John Templeton. Years after his death, he’s still acknowledged as an exemplary person and great investor. But you don’t have to be adorable to be a good investor. Dan Loeb, a sometimes off-colourful hedge fund manager, wrote a classic investment letter to investors in his Third Point hedge fund summarizing his results in the fourth quarter of 2012. It’s available on Zero Hedge along with the news that he’s taken a long position in Herbalife (more on that later).
High Potential of Gain
Managing money is a tough business. First you have to have the guts to exploit opportunities when everyone else is screaming in fear and running in the other direction. Loeb did that with investments in Greek Government Bonds, Yahoo! Inc, Murphy Oil Corp, Delphi Corp and American International Group Inc. That’s very difficult in itself, and that’s not even the toughest part.
Control Your Losses
The most successful investors in the world have trouble controlling losses. One investor who articulated that well was John Templeton. Many people don’t know that he was not only a brilliant investor, he was a talented short seller. He shorted tech company IPOs before the lock-up period expired allowing employees to sell shares. If the stock did not go down as he expected and popped up instead, he would cut his losses. He didn’t try to explain why it happened; it just did, and he followed pre-set rules he created for himself, because in those situations, the most important thing to remember is to not box yourself in with an oversized position, and above all, control your losses.
Few managers discuss controlling losses as Dan Loeb did it in his letter. His top fiver losers were Apple, Inc., Gold, Short A, Short B, and Overseas Shipholding Group Inc. Loeb notes:
A disciplined approach to avoiding major losses resulted in only four positions that detracted more than 25 basis points from overall performance.
In the fourth quarter of 2012, his fund was up 9.2%, and for the entire year, it was up 21.2%. He has a good track record in prior years, too. That doesn’t mean that it will continue, but his approach seems to keep the probabilities in his favour by finding opportunities that limit his downside while having a high probability of upside. Important in this formula for success is that he’s diversified the portfolio and exercises discipline in controlling his losses.
On December 23, I wrote that I agree with Bill Ackman, head of hedge fund Pershing Square, that Herbalife is ripe for investigation. I believe that not because of his presentation, which made some excellent points, but because of the lack of scientific evidence that Herbalife’s products have any advantage over generic products and a thorough reading of a Belgian court decision that discusses its evidence that suggests Herbalife is a pyramid scheme. Herbalife is appealing that decision.
Mr. Ackman has publicly stated he believes Herbalife is a pyramid scheme that bleeds a demographic dry and then moves on to either a new country or a new demographic within the same country. Herbalife’s demographic of choice in the United States at the moment seems to be the Hispanic community. Apparent earnings growth is at the expense of duped low income people that lose their “investment” when they are unable to recruit additional duped distributors as the base of the pyramid quickly fills up. Bill Ackman believes the company’s share price has significant downside, perhaps even zero, but his disclaimers also note that he may cover his short at any time, which would eliminate his bet altogether.
Mr. Loeb and his advisors disagree with this assessment and point to the cash flows and multi-year earnings growth generated by Herbalife and its apparent low valuation to historic P/E ratios, among other things. He notes that management historically returned net income to shareholders in the form of dividends and share buy-backs.
Only one of these gentlemen will win the argument, but which of them is winning on the Herbalife bet? At the moment, both Bill Ackman and Dan Loeb appear to be winning. Ackman has a huge short position on Herbalife, around 20 million shares, but it appears he initiate this short when Herbalife was more than 10 points higher than it is today, which means that on paper, he’s made money on this trade. Dan Loeb has taken a long position in 8.6% of Herbalife, and he thinks the company is worth $55-$68 giving him 40-70% upside. It appears that Loeb bought the stock at a much lower price after Ackman’s challenge to Herbalife, and the price has popped up since then. Loeb’s investment seems sized better relative to his $10.2 billion portfolio. Both men can end up being “right” on their bet by consolidating gains or controlling losses (erosion of gains) as the case may be.
Herbalife: What per cent are Retail Customers that Haven’t Signed Distributor Agreements?
Herbalife has an Analyst Day meeting today, and financial journalists will be watching to see how CEO Michael Johnson justifies his claim that 90% of Herbalife’s customers are outside of the distribution network. On January 4 CNBC reported that Kate Kelly got Herbalife’s CEO on the record:
Kate: Can you give us a percentage figure … Mr. Johnson as to what percentage of your sales are outside of that distribution network?
Johnson: 90 per cent?
Kate: So the vast majority?
It seems to me that Mr. Johnson will have to produce credible evidence to support this assertion if he is to be believed.
See also: “OMG! Dan Loeb Said What?” by Matthew Goldstein – Reuters, March 11, 2011, and “Bill Ackman is Right About Herbalife: It’s Ripe for Investigation,” Huffington Post, December 23, 2012.Read more posts on Tavakoli Structured Finance »